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School

University of Ottawa

Department

Economics

Course

ECO1104

Professor

David Gray

Semester

Fall

Description

ECO 1104 B Nov 5 , 2013
YUJIE YI #7038840
Chapter 10 Externalities
Externalities
 Negative externality: any negative spillover cost stemming from a production
activity that is imposed on a party other than the decision maker
- Decision maker does not face the external cost
- Examples:
 Acrack house operating next to a day-care centre
 Textbook case: a pulp and paper mill upstream from a fishery
 Positive externality: any positive spillover benefit stemming from a production
activity that is imposed on a party other than the decision maker
- The decision maker does not reap the external benefit
- Examples:
 OC transpo and stores near the transit way
 Textbook case: beekeeper and orchard
1  Both positive and negative externalities cause Market Failure in the form of an
Inefficient level of output
 Free market quantity will not be the most efficient one, if either positive
externality or negative externality exists.
- Reminder: efficiency means that total surplus is maximized at the level of
production
- Equivalently, the marginal benefit, which is the consumer’s willingness to pay
for the last unit, equals the suppliers’valuation of the last unit, which is the
cost of production (opportunity cost of production).
- The implication is that in the presence of an externality, that efficient level of
output is not attained.
Pollution – Negative Externality
 What is the optimal level of output for a polluting firm?
 Regarding to greenhouse gases
 How much oil should we allow to produce?
- Zero, say the environmentalists
- NOT zero, say the economists
 How can that possibly be? th
ECO 1104 B Nov 5 , 2013
YUJIE YI #7038840
 Typically, the polluting firm produces something that is valued by consumers, so
some output, and therefore some pollution as a by-product, should be produced.
- Since automobiles cause air pollution, why not immobilize al motor vehicles?
 Because Adjustment Costs should be considered.
 Figure 10.2 Pollution and the Social Optimum
- Since some toxics and substance are brought during the production of
aluminum. The cost should be taken into consideration.
- Thus, we end up in 2 supply curve – supply curve and social cost curve (
 Social cost: all the cost the firm faces including private cost (the firm
actually does have to pay) + costs of pollution (which the firm does not
care about)
 Social cost curve is notional. (that has to be estimated)
 Cost of pollution is the vertical distance between those 2 curves
 Governments have to deal with the cost of pollution behalf of the society
 The intersection of the demand curve and the social-cost curve determines the
optimal output level.
- The socially optimal output level is lower than the market equilibrium
quantity
3 - From the point of view of society, we are over-producing at the market level
of output (no interven